Unit 4 - Types & Characteristics of Derivative Securities (Study Guide)

Question 1

What are Derivative Securities?

Answer 1

They derive their value from an underlying instrument, such as a stock, stock index, interest rate, or foreign currency.

Question 2

What do option contacts offer investors?

Answer 2

A means to hedge, or protect, an investment’s value or speculate on the price movement of individual securities, markets, foreign currencies, and other instruments.

Question 3

What is an Option?

Answer 3

An option is a contract that establishes a price and time frame for the purchase or sale of a particular underlying instrument.

Question 4

Who are the two parties in an Option Contract?

Answer 4

Two parties are involved in the contract: one party receives the right to exercise the contract to buy or sell the underlying asset; the other is obligated to fulfill the terms of the contract.

Question 5

What is the most familiar Options?

Answer 5

Those issued on common stocks, they are called Equity Options.

Question 6

Your customer is long 10 ABC Jul 50 calls at 4.50. How many shares of stock will change hands if the option is exercised?

A. 10
B. 100
C. 1,000
D. 10,000

Answer 6

C. One of the three standardized terms of equity options is that each contract is for 100 shares. Therefore, the exercise of 10 calls (or puts, for that matter) will involve 10 × 100 or 1,000 shares.

Question 7

The value of a derivative is based on:

A. the value of the underlying asset.
B. the value set by the CBOE.
C. the face amount of the derivative.
D. the time until the underlying asset expires.

Answer 7

A. The reason for the term derivative is because these securities derive their value from the underlying asset. In the case of equity options, the subject covered on the exam, it is the value of the stock that the options are based on.

• The CBOE is a primary regulator of the options market but has nothing to do with determining value.
• The term face amount is meaningless.
• It is the option that expires, not the underlying corporation.

Question 8

All of the following are standardized for equity options except:

A. the size of the contract.
B. the expiration date.
C. the maximum profit.
D. the exercise or strike price.

Answer 8

C. The three standardized features of listed equity options are:

• The size of the contract on the underlying asset—that is, all options on XYZ stock are for 100 shares of the XYZ common stock.
• The expiration date—All options that expire in June (or July or whatever month) have the same date and time of expiry.
• The exercise or strike price—Strike prices are set at standardized intervals.

The amount of profit (or loss) is not standardized. As we’ll see later in this unit, there is potential for an unlimited profit or an unlimited loss.”

Question 9

What are the two types of option contracts?

Answer 9

Calls and Puts

Question 10

What is a call option?

Answer 10

A call option gives its holder the right to buy a stock for a specific price within a specified time frame. A call buyer buys the right to buy a specific stock, and a call seller takes on the obligation to sell the stock.

Question 11

What is a put option?

Answer 11

A put option gives its holder the right to sell a stock for a specific price within a specified time frame. A put buyer buys the right to sell a specific stock, and a put seller takes on the obligation to buy the stock.

Question 12

What is an options cost called?

Answer 12

A Premium

Question 13

Which of the following statements regarding derivative securities is not true?

A. Derivatives can be sold on securities and nonsecurities.
B. An option contract is a derivative security because it has no value independent of the value of an underlying security.
C. An option contract’s price fluctuates in relationship to the time remaining to expiration as well as with the price movement of the underlying security.
D. An owner of a put has the obligation to purchase securities at a designated price (the strike price) before a specified date (the expiration date).

Answer 13

D. Although equity options are the most common derivative on the exam, derivatives can be sold on any asset. For example, there are options on foreign currency and commodity futures where the underlying asset is not a security. For this question, an owner of a put has the right, not the obligation, to sell, not purchase, a security at a designated price (the strike price) before a specified date (the expiration date). That makes choice D the untrue statement. It is only the seller of an option who has an obligation.

Question 14

A customer has the right to sell 100 shares of MNO at 60 any time between July and October. Which term best describes this situation?

A. Long call
B. Long put
C. Short call
D. Short put

Answer 14

B. The put buyer (long position) has the right to sell stock to a put writer who is obligated to buy that stock.

Question 15

What are the types of options transactions?

Answer 15

• Buy calls
• Sell calls
• Buy puts
• Sell puts

Question 16

As to buyers and sellers, which one is which as to positions (long or short)?

Answer 16

Options buyers are long the positions; Option sellers are the short positions

Question 17

What are the three ways to close a position?

Answer 17

1. Sell the option contract before the expiration date;
2. exercise the option to buy or sell the security specified in the contract; or
3. let the option expire.

Question 18

What are the potential opening and closing positions?

Answer 18

To Open - To Close
Buy call - Sell call
Sell call - Buy call
Buy put - Sell put
Sell put - Buy put

Question 19

What is the difference between American- and European-style exercises?

Answer 19

American style means the option can be exercised at any time the holder wishes, up to the expiration date. European-style options may only be exercised on the last trading day before the expiration date.

TIP: A for American means Anytime; E for European means Expiration date.

Question 20

What is the length of an option contract?

Answer 20

Options are available that are issued with an expiration date of as short as one week to as long as three years.

The short-term ones are called weeklys, and the long-term ones are known as LEAPS (Long-Term Equity Anticipation Securities). Most standard options are issued with an expiration length of a maximum of nine months.

Question 21

Are all options, regardless of their length, derivative securities?

Answer 21

Yes

Question 22

Options strategies are one of two. What are they?

Answer 22

Bullish or Bearish. Bullish believes the price of the security will go up; Bearish believes the price of the security will go down.

Question 23

What are to primary reasons for buying or selling options?

Answer 23

To profit from or hedge (protect) against price movement in the underlying security.

Question 24

Bullish and Bearish Options Positions

Answer 24

Question 25

What is writing calls?

Answer 25

Writing call options is a process of giving a holder the right but not the obligation to buy the shares at a predetermined price. Whereas, in writing a call option, a person sells the call option to the holder (buyer) and is obliged to sell the shares at the strike price if exercised by the holder. The seller, in return, receives a premium that is paid by the buyer.

Question 26

Why would you want to buy puts?

Answer 26

A bearish investor—one who believes a stock will decline in price—can speculate on the price decline by buying puts. A put buyer acquires the right to sell 100 shares of the underlying stock at the strike price before the expiration date.

Question 27

Why would you want to write puts?

Answer 27

investors who write puts believe that the stock’s price will rise or remain stable.

A put writer (seller) is obligated to buy stock at the exercise price if the put buyer puts it to the put writer. If a stock’s price is above the put strike price at expiration, the put expires unexercised, allowing the put writer to keep the premium. Just as with writing calls, receiving that premium is a source of income. Put writers will lose if the stock price falls (the buyer “wins”), but the loss is limited because the stock price can never fall below zero.

Question 28

Why purchase a straddle?

Answer 28

When an investor is not sure which direction the market will move but has a strong opinion that there will be dynamic movement, a strategy that might be employed is the purchase of a straddle. This is the combining of a put and a call on the same stock with the same exercise price and expiration date. If the stock moves up, a profit is made on the call; if it moves down, a profit is made on the put. Those who buy a straddle will profit from volatility, while those who sell a straddle will profit if the market is stable because the options will expire unexercised.

Question 29

What is a stock right?

Answer 29

A stock right, sometimes referred to as a preemptive right, is a privilege extended to existing holders of a company’s common stock. When the company is going to issue additional shares of common stock, in order to prevent dilution of ownership by the current owners, they are given the right to preempt (come ahead of ) any members of the general public and have the first shot at the new stock.

Question 30

What are key points about Rights?

Answer 30

• They are given (not sold) to existing holders of the common stock.
• They are exercisable at a price below the current market.
• They have a short lifespan—they will expire in no more than 45–60 days, sometimes less.
• They can be sold and then the buyer can exercise them.
• Although generally unwise to do, they can be left to expire.

Question 31

What is a warrant?

Answer 31

Unlike rights, warrants have an exercise price above the current market price, and, unlike rights, they have no relationship to an existing stockholder’s proportionate interest. Another difference is that warrants have a long expiration period, sometimes as much as 10 years.

They are usually attached to a bond issue (their attractiveness sweetens the issue, frequently allowing for a lower interest rate on the bond) or are attached to a new stock offering where the package is considered a unit, such as 1 share of stock with a warrant to purchase another share. In most cases, warrants can be detached and sold separately.

Question 32

Key points to remember about warrants?

Answer 32

• They are exercisable at a price above the current market. Why would anyone be interested in that? Because you might have a five-year expiration period and have the right to buy the stock at $45 when it is selling at $40 today. If you think there is a chance that the stock’s price will move more than 5 points in five years, you can make money—sometimes lots of money because of the leverage.
• Their “life” is considerably longer than rights and longer than call options as well.
• When detached, they can be traded like any other security (they are usually traded on the same exchange as the company’s common stock).
• Most securities professionals view warrants as call options with a very long time to expiration.
• Warrants do not have voting rights, nor do they receive dividends—the same as any other derivative.

Question 33

What’s the major difference between call options and rights/warrants?

Answer 33

Options originate on the exchange on which they are traded, whereas rights and warrants originate with the issuer of the stock. The effect of this is that new shares are issued when a warrant is exercised, while exercise of a call option requires the assigned seller to deliver existing shares.

Question 34

GEMCO Manufacturing Company, traded on the NYSE, has announced that it will be issuing 10 million new shares of common stock to raise new capital for the purchase of new equipment. Your client, owning 1,000 shares of GEMCO common stock, would probably receive:

A. an advance invitation to purchase some of the new shares.
B. options to purchase some of the new shares.
C. preemptive rights to purchase some of the new shares.
D. warrants to purchase some of the new shares.”

Answer 34

C. Commonly, when a publicly traded company issues new shares of common stock, existing shareholders receive rights, sometimes called stock rights, enabling them to purchase shares in proportion to their current ownership, usually at a reduced price. These rights rarely last longer than 45 days and must be exercised or sold within that time or they’ll just expire worthless. Warrants are not sent to shareholders; they are either purchased in the open market or come attached to a new issue of securities as a “sweetener.”

Question 35

Which of the following statements concerning put and call options is not correct?

A. One call option is an option to buy 100 shares of a particular common stock at a specified price.
B. A put option permits investors to speculate on a rise in the price of an underlying common stock without buying the stock itself, and a call option allows investors to speculate on a decline in the stock price without short selling the common stock any time prior to a specified expiration date.
C. One put option gives the buyer the right to sell 100 shares of a particular common stock at a specified price prior to a specified expiration date.
D. Options may be used as a hedge against a portfolio position by establishing an opposite position in the option contracts.”

Answer 35

B. It is the call option that permits investors to speculate on a rise in the price of the underlying common stock without buying the stock itself and the put option that is the alternative to selling stock short.

Question 36

All of the following statements describe preemptive rights except:

A. they are most commonly offered with debentures to make the offering more attractive.
B. they are short-term instruments that become worthless after the expiration date.
C. they are issued by a corporation.
D. they are traded in the secondary market.

Answer 36

A. A corporation issues rights to existing shareholders to allow them to purchase enough stock, within a short period and at less than current market price, to maintain their proportionate interest in the company. Rights need not be exercised but may be traded in the secondary market. Warrants, not rights, are often issued with debentures to sweeten the offering.

Question 37

What is a forward Contract?

Answer 37

A forward contract is a direct commitment between one buyer and one seller. If the position is held until the closing date, the forward seller is obligated to make delivery; the forward buyer is obligated to take delivery. A forward contract is nonstandardized. Its unique terms are defined solely by the contract parties without third-party intervention. This arrangement ensures a ready market or supply source because it presumes delivery.

Question 38

What is counterparty risk?

Answer 38

Each party risks the credit and trustworthiness of the other.

Question 39

What are forward contracts?

Answer 39

Forward Contracts are exchange-traded obligations. The buyer or seller is contingently responsible for the full value of the contract. That is, unlike with forwards, obligations are created only when the contract is exercised.

Question 40

What are the five components of a typical forward contract?

Answer 40

1. Quantity of the commodity;
2. Quality of the commodity;
3. Time of delivery;
4. Place for delivery; and
5. Price to be paid at delivery.

Question 41

What are the five parts to an exchange-traded futures contract?

Answer 41

1. Quantity of the commodity (e.g., 5,000 bushels of corn or 100 ounces of gold)
2. Quality of the commodity (specific grade or range of grades may be acceptable for delivery, including price adjustments for different deliverable grades)
3. Delivery price (similar to exercise or strike price with options)
4. Time for delivery (e.g., December wheat to be delivered)
5. Location (approved for delivery)”

Question 42

Who most commonly uses Futures? Forwards?

Answer 42

Futures are most commonly used by producers. While Forwards are used by producers.

Question 43

Forwards are commonly used by producers (farmers) to hedge the risk of the price of the commodity falling before it is able to be harvested and sold. For example, if a farmer has planted soybeans and wishes to hedge against a possible decline in the spot or cash price at delivery, the farmer could:

A. buy forward contracts in a size equal to the amount of the soybeans expected to be harvested.
B. buy futures contracts in a size equal to the amount of the soybeans expected to be harvested.
C. sell forward or futures contracts in a size equal to the amount of the soybeans expected to be harvested.
D. sell the soybeans for cash today.

Answer 43

C. Hedging a commodity yet to be harvested is done by selling a forward or a futures contract on that commodity. Invariably, producers will use forward contracts but could also use a futures contract. In that way, the price is guaranteed in the event of a market decline. However, the producer is giving up any potential gain in the event the prices rise above the futures/forward agreed-upon one.

Question 44

As is the case, a clearing firm is the counterparty and guarantor of exchange-traded activity, acting as the buyer to all sellers and seller to all buyers. This eliminates counterparty risk when investing in futures contracts.

Question 45

An investor takes a long position in a commodity forward contract at a forward price of $105 when the spot price (current market price) is $102. One month later, the spot price has increased to $110. At that time, the forward price of the contract is:

A. less than $105.
B. $105.
C. between $105 and $110.
D. greater than $110.”

Answer 45

B. The price of a forward contract is agreed upon between the buyer and seller at initiation. Remember, forward contracts are not standardized like futures contracts. The value of the contract may change during its life, but not the exercise price. Because forwards tend to be confusing, think of this in the manner of an equity call option. The customer buys a 105 call when the stock’s price is $102. One month later, the market price of the stock has risen to $110. What is the strike price? It is still 105. Same concept here.

Question 46

A commodities speculator purchases a 1,000-bushel wheat futures contract for 80 cents per bushel. At expiration, the settlement price is 70 cents per bushel. This individual:

A. has a $100 gain.
B. has a $100 loss.
C. must make delivery of the wheat.
D. effectively hedged the long wheat position.

Answer 46

B. The simple math is this: The individual bought at 80 cents and sold at 70 cents, losing 10 cents per bushel. Multiply 10 cents ($.10) by 1,000 bushels, and the loss is $100. It is the seller who is obligated to deliver; the buyer
of the contract must accept delivery (unless there was an offsetting transaction prior to expiration). This individual was long the futures contract, not long (the owner of ) the wheat.

Question 47

As it relates to derivatives, what is leveraging?

Answer 47

Because an option’s cost is normally much less than the underlying stock’s cost, option contracts provide investors with leverage: relatively little money allows an investor to control an investment that would otherwise require a much larger capital outlay. And, if you purchase a call and “guess right,” the potential profit is unlimited (theoretically, there is no limit as to how high the stock’s price can go). Leverage works both ways. possible loss of everything when it doesn’t.

Question 48

What is selling short?

Answer 48

Selling stock short involves putting up a deposit in a margin account and borrowing stock to sell, and carries with it the possibility of an unlimited loss. When you buy a put, you benefit when the stock’s price declines, but all you pay is the premium and, if you guess wrong, that is all you can lose.

Question 49

What does time decay mean?

Answer 49

Time decay is the concept that as the time to expiration gets closer, the value of the option decreases.

Question 50

Who does taxation from buying/selling options work?

Answer 50

In most cases, any profits realized from buying or selling options is considered a short-term capital gain.

Question 51

Here is the type of question that is basically easy, but, if you don’t read carefully, you will waste time trying to figure it out. Among the purposes of purchasing derivatives would be all of the following except:

A. hedging.
B. income.
C. profits.
D. speculation.”

Answer 51

B. Purchase of a derivative, whether an option, a forward, or a futures contract, never generates income. Selling one does, but the question refers to a purchaser, and that is why the correct answer is choice B.

Question 52

The term derivative would not include:

A. futures on commodities.
B. interest rate swaps.
C. REITs.
D. LEAPS.

Answer 52

C. A derivative is something that derives its value from something else. REITs represent direct investment into real estate; the asset purchase is the actual asset. LEAPS are the options with long-term expiry. Never heard of interest rate swaps? Well, on the real exam, there will occasionally be an answer choice that you’ve never heard of, but it should not affect your ability to choose the correct one.

Question 53

Writing options can be a useful method of generating a stream of income for your customer’s portfolio. One issue to be considered is that:

A. the income is generally tax free.
B. the income is generally taxed as short-term gain.
C. the income is generally taxed as long-term gain.
D. the writer of the option controls whether or not the option is exercised.

Answer 53

B. The nature of selling options is such that the IRS generally considers the income generated to be taxable as a short-term gain. Currently, the rate of tax on those gains is significantly higher than on long-term gains. It is the owner (holder) of the option, not the writer, who has control over the decision to exercise. Note that for testing purposes, invariably when there are two choices that are mutually exclusive (taxed short term, or taxed long term), one of those will be the correct answer.